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CEMIS: Department of Economics

ECON 121: Principles of Micro Economics Note: Students are required to refer the text, internet and other resource materials

(Lecture points only)

Part I: Basic Concepts

Chapter – 1: Introductory material

Origin of the word “Economics”

The word Economics is derived from the Greek word: “Oekov Nomia” which means ‘principles (norms) of household management’. In the modern sense, it refers to the management of the economy’s (country’s) resources.

Distinguish between Micro Economics & Macro Economics.

Micro Economics Macro Economics- Micro Economics deals with “parts” of the economy. It takes a sectional view rather than a general view of the economy.- It analyses the behavior of individual units of an economy. It talks about individual household, individual firm, price of particular commodities, etc. - Study the individual trees, not the forest. - Depends on Macro Economics analysis

- Study of the economy as a whole. Study of aggregate economic behavior, example, general price level, total national income of the country.- Attempt an overall view of the economy- It is like viewing from the top a “forest” not the “individual-trees” constituting that forest.- Depends on Micro Economics analysis

What is Economics? The study of how best to allocate scarce resources among competing uses.

(Explanation)Economics is mainly concerned with the efficient use of limited resources to satisfy human wants. Human wants are unlimited while productive resources (means) are limited. This leads to the problem of how to use the scarce resources to obtain maximum satisfaction.

Definitions of Economics

1) Wealth definition of Adam Smith: (Father of Economics) "Economics is the science which studies the nature and cause of the wealth of nations" . His book: “Wealth of Nations” Published in 1776

2) Welfare definition Alfred Marshall: ‘Principles of Economics’ published in 1890.

For the well being or welfare of people, for making people happy.

3) Scarcity definition of Lionel Robbins: Prof. Lionel Robbins of the London School of Economics in his challenging book: "An Essay on the Nature and Significance of Economic Science" published in 1932 “Economics is the science which studies human behavior as a relationship between ends and scarce means which have alternate uses”

This definition has modern relevance or application.

Explanation:

1) Unlimited Wants (demands):“Ends” here refer to wants or demands. Human wants are unlimited in number. When one want is satisfied, another want comes up with greater intensity. They are repeated.

2) Limited (scarce) resources:“Means” here refers to resources such as land; raw materials, machines etc are not enough in relation to wants or needs. 3) Alternate (other) uses of resources:The limited resources have alternate uses. It means it can be put to different uses. For example, land can be used for cultivation, construction of building, road, park, etc. (ref. opportunity cost)4) Problem of choice:Hence, we have to choose that want which is very urgent. We have to produce ‘modern-bread’ instead of ‘motor-car’ if people do not have food.

What is true of an individual is also true of an economy or a country. Hence, we have to study the central (basic) economic problems. (Eco: problems faced by the country or the Govt.)

Summary chart of the Basic Economic Problem(Based on Lionel Robbins’ definition)

Economic Problem

Wants (demands) Resources

(means)

Unlimited & recurring Limited (scarce)

Differ in importance Alternative (other) uses

Algebra of Choice

The Four Factors of Production with their rewards

LAND (Rent)

(Entrepreneurship) ORGANIZATION Production LABOUR (Profit / Loss) (factory) (Wages/salaries)

CAPITAL (Interest)

Define Factors of Production.

Resource inputs used to produce goods & services such as land, labor, capital and organization.What are the four basic factors (agents) of production? Explain. (Fill in from Text)

1) Land: Anything freely given by nature. Eg. Air, water, crude oil, minerals.

2) Labor: skills and abilities to produce goods / services.

3) Capital: produced-means of further production. Final goods produced for use in further production.

4) Entrepreneurship: One who brings together the factors of production.

The central economic problems (basic decisions)

What is true of an individual is also true of an economy or a country. Hence, we have to study the central (basic) economic problems. (Eco: problems faced by the country or the Govt.)

1) What to produce? Modern bread or Motor car? Guns / butter?

How much of each goods to be produced.

2) How to produce? Refers to Technology

a) Labor intensive technique- More amount of labor &less amount of capital.(machine)b) Capital intensive technique-More amount of capital & less amount of labor c) The Third Technology: Combine both. E.g. PDO

The best technique is that which is most efficient. Efficiency is maximized by economizing scarce resources

3) For whom to produce? Rich or poor? Distribution of what is produced.

Who will get what is produced?

Opportunity Cost:The cost of foregoing (give up or sacrifice) the next best alternative.The most desired goods and services that are foregone in order to obtain something else.

Production Possibilities:

The alternative combination of final goods and services that could be produced with available resources and technology, in a period of time.

Producing more of one commodity means producing less of another.

Production Possibilities Curve

Refer diagram (P.7) and draw here:Production Possibilities: (definition)The alternative combination of final goods and services that could be produced with available resources and technology, in a period of time.

Producing more of one commodity means producing less of another.

Production Possibilities Curve or Frontier:

The central problems of the economy can be diagrammatically illustrated with the help of

the production possibility frontier. It is assumed that the society produces two types of

goods - guns (defence goods) and butter (civilian goods). Guns are marked along the Y

axis and butter along the X axis. Full and efficient utilization of the available resources

will produce either OA of guns or OB of butter. The curve AB is the production

possibility frontier. Any point other than A and B on the PPF shows a combination of

guns and butter that can be produced with the given resources. The points CDEF are

some of the combinations of guns and butter open to the society. Any point inside the

area OAB, say point N, shows that the resources are not fully or efficiently utilized. The

shift from this point to any point on the PFF shows the production of more guns or more

butter or more of both. Further shift out ward from the PPF to say point M is impossible

because it is assumed that the resources available and the method of production arc given

and constant.

Let us suppose that the chosen point along the PPF is E with OI of guns and OJ of butter.

If the society wants to increase the production of butter from OJ to OL, ie by JL, the

production of gun is to he reduced from OI to OK because the available resources are

fully and efficiently employed already. Thus butter substitutes guns. The problem of

choosing a point along the production possibility curve, which gives maximum

satisfaction to the community, is known as the problem of technological choice. The

chosen point along the production possibility curve, say E shows what goods are to be

produced and in what quantities. If the full utilization of the resources results in an output

which lies along the Production possibility curve, the method of production adopted is the

most efficient one. The question of how much for each cannot be answered from the PPF

alone. But we can have a rough idea of the nature of distribution from the PPF.

The PPF also answers the question of economic growth. If a growth of resources takes place in the economy, the production possibility frontier will shift upward to the right as shown in the above diagram by the curve GH. Any point along GH will produce more guns or more butter or more of both. Therefore the shift from AB to GH represents economic growth. If a technological improvement takes place, the economy may produce more with the given resources. This also results in economic growth or the upward shift of the PPF.

Mechanism to solve the economic problem:

How these central (basic) problems are solved in capitalist, socialist and mixed economies?

Capitalist Economy & Price-Mechanism:

Capitalist economy is a system in which the factors of production (land, labor, capital and organization) are privately owned. Profit motive and self-interest influence all economic activities. It is a free economy.

Laissez faire = leave it alone, non-intervention by Govt.

There is full freedom in the economic field. Here no single person, institution or govt. gives any direction for economic decision of what, how and for whom to produce. This work is done by price-mechanism in this economy.

Price-mechanism works through the forces of demand and supply in the market. The price of a commodity is determined at that point where the demand and supply of that commodity are equal. This is called the equilibrium price or market price. Market mechanism: The use of market prices and sales to signal desired outputs. (P.13)

In a capitalist economy no body fixes the price in a market but automatically fixed by this price mechanism.

This price-mechanism or market mechanism becomes the basis of economic decisions. It solves the problems of what, how and for whom to produce.

Market Failure:When market signals do not give the best possible answers to the what, how, and for whom questions, we say that the market mechanism has failed.

The invisible hand has failed.

It is an imperfection in the market mechanism that prevents optimal outcomes.

Socialist Economy & Planning:

Govt. intervention & Command economies (P.13)

Socialist economy is a system in which the whole community owns the means (factors) of production. The central authority takes all economic decisions. It is a command economy. There is a direction from the center.

The central planning authority through planning solves the central problems of what, how and for whom to produce. Ref. The Five Year Plans in Oman.

The central planning authority decides the order of preference in which different commodities should be produced. Importance is given for social benefit rather than profit motive. All the people in the country should receive the benefits.The concept of welfare-state in Oman.

Govt. Failure:Govt. intervention that fails to improve economic outcomes or actually make them worse (P.16). Eg: The down fall of Communism in Russia.

Solution of Central problems in a Mixed Economy:

It is a system in which the means (resources) of production are owned and managed partly by the private individuals (private sector) and partly by the government (public sector)

It is a mixture of the elements (features) of capitalism and socialism. Hence, it is a mid way between the two.

Mixed Economy: An economy that uses both market signals and Govt directives to allocate goods and resources. (P.15)

The basic economic problems are solved through a combination of central planning and price-mechanism. In a mixed economy, the private sector is made to work and cooperate through encouragements & promotions, checks &controls, etc. If the private sector is shy to invest, the govt. directly invests.

Class Participation / Revision

NB: Keep a graph book for diagrams and lecture points

Answer in points after referring the Text Book.

1. Define and explain the scarcity definition of Lionel Robbins.

2. Define Production Possibilities. Draw the Production Possibility Curve on a graph paper and plot on it points attainable, unattainable, attainable but inefficient use of resources.

3. What happens to PPC if more resources and better technology made available?

4. Explain the basic (central) problems of an economy.

5. Briefly explain the three systems of an economy with examples

6. How these central (basic) problems are solved in capitalist, socialist and mixed economies?7. Explain the four factors of production with examples.


ECON 121: Principles of Micro Economics

Note: Students are required to refer the text, internet and other resource materials

Chapter – 2: Demand , Supply & Equilibrium (P. 58 of Text)

Introduction:

Demand can be defined as the quantity of a commodity or service, which a consumer is willing and able to buy at a given price over a given period of time.

E.g. 1 kilogram of fish at RO. 2 this week or today.

Effective demand:

The word ‘demand’ has a particular meaning in Economics. Demand in Economics means ‘effective demand’. Demand in ordinary sense means ‘mere desire’. Mere desire does not constitute demand in Economics. A desire for a commodity becomes demand only when it is backed up by the money to buy and the willingness to pay.

“The desire for a commodity backed up by the ability to buy and willingness to pay”.

Demand schedule:

A demand schedule is a tabular statement of the relationship between the price and the quantity demanded of a commodity. It states the different quantities of a commodity that would be demanded at different prices.

There are two types of demand schedules:

1) Individual demand schedule

2) Market demand schedule.

1) Individual demand schedule:Individual demand schedule states the different quantities of a commodity which an individual consumer would buy at various prices.

An imaginary individual demand schedule is given below.

Price per Kg

Apple in

OMR.

Qty of Apples

demanded per week

5 10

4 20

3 30

2 40

1 50

A graphical representation of the individual demand schedule is known as the individual

demand curve. It slopes downwards from left to right in accordance with the law of

demand.

The Market Demand:

It may be defined as the total quantity of a commodity demanded by all the

individuals or households in the market at a price for a given period of time. The market

demand also will be different at different prices. Therefore a market demand schedule

may be defined as the table of the total quantity of a commodity demanded by all the

buyers in the market at different prices for a given period of time. When the schedule is

transferred into a diagram we get what is called the market demand curve. The following

example will make the idea clear. For the sake of simplicity let us assume that there are

only 3 buyers in the market for apple, namely A, B and C. Columns 2, 3 and 4 represent

the respective demand for apple by the three individual buyers. We get the market

demand per week when we add the demand for apple by all the three individual buyers in

the market at each price. The diagram given below is drawn as per the market schedule.

A, B and C are the individual demand curves. MD is the market demand curve and it

shows the relationship between the 1st column and the last column in the table below, ie.

between price and market demand. The horizontal summation of the three individual

demand curves gives us the market demand curve.

Price per Kg of

apple in OMR.

Demand for apples by the buyers

per week

Market

demand for

A B C apples per week

5

4

3

2

1

5

10

15

20

25

5

15

25

35

45

30

35

40

45

50

40

60

80

100

120

What are the factors which affect the demand for a commodity?

Two types of factors:1) Price factor: Here the price is the main factor

2) Non-price factors: factors other than price-changes.

a) Income of the consumer: There is a direct relation between the income and quantity demanded.

Normal goods:Goods for which demand goes up when income is higher and for which demand goes down when income is lower.

Inferior goods:Goods for which demand tends to fall when income rises.

b) Price of substitutes:Goods that can serve as replacements for one another; when the price of one rises, the demand for the other goes up. Example, Tea / Coffee.

c) Price of Complementary goods:They are the jointly demanded goods. Goods that go together. Example, car and petrol. When the price of car falls, more petrol will be demanded.

d) Tastes and preferences, fashions, etc.

e) Advertising:

f) Expectations of future price changes:

The Law of Demand:

The quantity demanded of a commodity varies inversely with its price, other

determinants of demand remaining unchanged. (Ceteris Paribus)

This is graphically represented below.

The quantity demanded is marked along the X axis and the price along the Y axis.

DD is the demand curve which is drawn according to the law of demand. It slopes

downwards from left to right, because more is demanded at a lower price and less at a

higher price. In the diagram, at a higher price of OA the quantity demanded is only OM.

When the price falls to OA1 the demand expands to OM1

Assumptions of the Law of Demand

The law of demand discussed above is based upon the following assumptions.

1. The tastes and habits of the consumers remain constant.

2. The incomes of the consumers remain constant.

3. The prices of other goods remain constant.

4. There is no new substitute for the commodity.

5. There is no expectation of a further change in the price.

6. The concerned commodity is not meant for conspicuous

consumption.

7. There is no change in the number of consumers.

A change in any of these will break the law of demand. It is to be noted that the

above conditions are subject to change in the long period. Therefore the law of demand is

true and valid only in the short period and not in the long period.

Supply Analysis

Supply can be defined as the quantity of a commodity or service, which a seller or producer is willing and able to sell at a given price over a given period of time.

E.g. Supply of 80 kilograms of Salalah beef at RO. 3 this week or today.

The Market Supply Curve

Price

(OMR. per kg.)

Quantity supplied

kgs.

1

2

3

4

5

40

60

80

100

120

Draw the Supply Curve

What are the factors which affect the supply of a commodity? (P.55)

1) Technology

2) Costs of production

3) Taxes & subsidies

4) Number of sellers

Law of Supply

Law of supply explains relationship between price and quantity of supply of a

commodity. The law states that, other things remaining the same, the quantity of any

commodity that firms produce and offer for sale rises with rise in price and falls with fall

in price.

The law thus states that higher the price, greater is the quantity supplied and lower

the price, smaller the quantity supplied.

Law of supply works on the assumption that other things remaining the same, that is

factors other than price that determine the supply of a commodity, will remain

unchanged.

Assumptions of the Law of Supply

1. There should not be any change in the income of the buyers.

2. There should not be any change in the habits and preferences of buyers.

3. Cost of production does not change.

4. Production technology remains same.

5. Law of supply applies at a particular time and in particular circumstances. A

change in these circumstances may cause a change in the law.

Equilibrium price (P. 58 of Text)

“Demand and Supply are like the two blades of a pair of scissors”

An Economist, Alfred Marshall compared the determination of price through the demand and supply with the cutting of a piece of paper by the two blades of scissors, the upper blade and the lower blade. Both the blades are required to do the cutting of paper. Similarly, both the demand and supply of a commodity are essential factors for determining its price.

Class Activity:Draw the combined diagrams of Market Demand & Market Supply curves in the graph book and note the equilibrium price.

Y D Surplus S

P1

Price P Equilibrium

P2Shortage D

O X Q

Quantity D. & S.

Equilibrium price:

It is the price at which quantity demanded of a commodity equals quantity supplied. There is no tendency for the price to rise or fall. At this equilibrium price the two forces of demand and supply exactly balance each other and therefore there is neither surplus nor shortage of the commodity at this price.

Determination of Equilibrium Price:Price Qty.

DemandQty

SupplyShortage/Surplus?

Tendency to change or not?

OP1 (higher price)

S > DSurplus

To move DOWN towards Equilibrium Price OP

(price falls gradually to eqlm)OP OQ OQ OQ = OQ,

no gapTo rest, a state of balance, hence

EQUILIBRIUMOP2

(lower price)

D > SShortage

To move UP towards the Equilibrium price OP.

(price rises gradually to eqlm)

Explanations:The term 'equilibrium' is derived from the Latin words 'asquus' and libra' which mean

equal balance. So the term equilibrium means a state of balance or rest. When two

opposite forces balance each other on a particular object, that object is said to be in a state

of equilibrium. The opposite forces in Economics are demand and supply. They may

balance each other at a particular price. That state of rest in which further change is not

desirable is called the equilibrium condition.

A market, in Economics, is defined as a group of buyers and sellers dealing in a particular

commodity. Market demand is the total quantity of a commodity demanded by all the

individuals or households in the market at a price for a given period of time. At the same

time the total quantity supplied by all the individuals or firms in the industry is called the

market supply of a commodity. A market is in equilibrium when the market demand and

the market supply of a commodity are equal at a particular price.

When quantity supplied exceeds quantity demanded it is called a surplus. Hence a

surplus causes the price to fall. When quantity demanded exceeds quantity supplied it is

called a shortage. Hence a shortage causes the price to increase.

CLASS ACTIVITY

Explain how demand and supply interact to determine prices of goods and services and the quantities exchanged.

The determination of prices in a market:(Exercises on market price determination)

Every economic good (commodity) has:

1) A demand-schedule that shows the different quantities demanded by the consumers (customers) at various prices during a given period of time.

2) A supply-schedule that shows the different quantities supplied by the producers (sellers) at various prices during a given period of time.

Equilibrium price:

The interaction (intersection) of Demand and Supply will determine Equilibrium price. It is the price at which the quantity the buyers wish to purchase is the same or equal to the quantity the sellers are willing to offer to the market. (Refer to the Market Demand & Supply schedules and combine the diagrams)

Surplus (Excess Supply): It is a situation where the Supply from the sellers is greater than the Demand of the consumers (buyers)

Draw the fig:

Shortage (Excess Demand):It is a situation where the quantity demanded by the buyers is greater than the quantity supplied by the sellers.

Draw the fig:

Changes in Equilibrium price (by changing demand and supply curves)

Market price is determined by the interaction (intersection) of Demand and Supply. The market price changes (due to) because of changes in Demand & Supply.

Effects of changes in demand (Increase / decrease in demand)

*If Supply remains constant (same), demand increases (demand curve shifts to the right), what happens to market price?

The market price (equilibrium price) rises as shown in the fig: (draw the fig. here)

*If Supply remains constant, the demand decreases (demand curve shifts to the left), what happens to the market price? The market price falls as shown in the fig:

Effects of changes in Supply (Increase / Decrease in Supply):*If the demand remains constant and supply increases, what happens to the market price? The market price falls as shown in the fig:

*If the demand remains constant and supply decreases, what happens to the market price? The market price rises as shown in the fig:

Increase in Demand & increase in Supply:*If both demand and supply increase (both shift to the right), the market price remains the same as shown in the fig:

*However, if demand increases (shift to the right) and supply decreases (shift to the left), what happens to the market price?The market price rises as shown in the fig:




Part II: Elasticity & Costs

Chapter – 5: Elasticity of Demand. (Refer Page 100 of your Text Book)

I. Price Elasticity of Demand – definition.

The percentage change in quantity demanded divided by the percentage change in price.

Price elasticity of demand refers to the degree (rate) of responsiveness of quantity demanded of a good to changes in its price, other things being equal.

That is, it tells us to what extent or by how much the quantity demanded of a good change in response to changes in its price.

^ q P Ep = ---- x ---- OR Ep = % change in quantity demanded

^ p Q % change in price

Types of price elasticity:

1) Perfectly elastic demand (Infinite elastic) (Ref. P. 102 Extremes of elasticities)Demand for a commodity is said to be perfectly elastic when there is a small fall in price, the demand for it may rise to any extent. On the other hand, when there is small rise in price, the demand is nil. The demand curve is horizontal line or parallel to X-axis.This is an extreme situation. Calculate price elasticity of demand and draw the figure here:

Demand for commodity X Price (RO) Quantity in units

3 53 2

2) Perfectly inelastic demand (Ed=0)Perfectly inelastic demand means changes in price do not affect the quantity demanded of the commodity at all. The demand curve is vertical line or parallel to Y-axis.This is also an extreme situation.

Calculate price elasticity of demand and draw the figure here:

Demand for Salt Price (Bz.) Quantity (Kilo)

100 1201 1300 1

3) Relatively elastic demand (Ed > 1)The percentage (proportionate) change in quantity demanded is more than the percentage change in its price. If a change in price results in a significant change in quantity demanded. (It is a flatter curve)


Demand for PetrolPrice (Bz.) Quantity (Litres)

120 1000100 1500

4) Unitary elastic demand (Ed = 1)If the percentage change in quantity demanded is exactly equal to percentage change in its price. Strictly speaking, a unitary demand curve is a rectangular hyperbola. A rectangular hyperbola is a curve in which the total area at different points on the curve will be the same. (Less steep)


Demand for ClothPrice (RO.) Quantity (Metres)

10 10015 50

5) Relatively inelastic (Ed < 1)If the percentage change in quantity demanded is less than the percentage change in its price. (It is a steeper curve)

Calculate price elasticity of demand and draw the figure here:Demand for Sugar.Price (Bz.) Quantity (Kilo)

500 10750 8

II. Income elasticity (Page 109)

Ei = % change in quantity demanded % change in income

Normal Good: Good for which demand increases when income rises. (+), Page 109

Inferior Good: Good for which demand decreases when income rises ( - )

III. Cross – Price Elasticity. (Page 111)

Ec = % change in quantity demanded of X % change in price of Y

Price of Complementary goods:They are the jointly demanded goods. Goods that go together. Example, car and petrol. When the price of car falls, more petrol will be demanded and vice versa.

If the cross price elasticity is positive (if you get an answer - ) the two goods are complementary goods.

Price of substitutes:Goods that can serve as replacements for one another; when the price of one rises, the demand for the other goes up. Example, Tea / Coffee.

If the cross price elasticity is positive (if you get an answer +) the two goods are substitutes.Class Activity:

Calculate the types of price elasticity of demand with the help of schedule and diagrams in your class participation book.

(Good luck)


ECON 121: Principles of Micro Economics

Note: Students are required to refer the text, internet and other resource materials (Lecture points only)

Chapter – 3: Application of Demand & Supply analysis to practical situations in an economy.

We have discussed the operation of the price mechanism. Price mechanism operates when there is no outside interference (control) with demand and supply forces. But we know that the Govt. can interfere with free operations of market forces. The govt. does interfere in the market through the following:1) Price controls: fixing the prices of goods sold in the market a) Ceiling price & Rationing (for consumers) P.65

b) Floor price (for farmers or producers)

2) Rent controls 3) Minimum wage legislations

1) Price controls:Price control means that a ceiling has been imposed on the prices of certain goods (sugar, rice, steel, cement, etc). The producers of these essential commodities cannot charge prices higher than the ceiling prices (maximum prices) fixed by the Govt. Here, the govt. purposely interfere in the price mechanism for the benefit of the consumers esp. the poor.

a) Ceiling price & Rationing:

Y D S

Price E

CEILING PRICE (Maximum price)Shortage D

O X Quantity D. & S.

A ceiling price is below the existing price level.

When the Govt. wants to pull down the prices, it imposes a price ceiling. When the Govt. fixes a price below the equilibrium price as shown the figure above, there will be shortage (deficit) because D > S. Hence, the govt. has to provide these goods through the ration shops at this price otherwise this will lead to black marketing.

Black marketing means illegal trade of these goods at a higher price by the private sector. Rent control:It means a price ceiling on rent of buildings, set by the Govt.

b) Floor price (Price support):

Price support means a “floor” (minimum price) is fixed for certain goods like wheat, Oman dates, etc. This is to help the producers to obtain a minimum price for their products otherwise they stop production of these goods. The equilibrium price is not good for them. Hence, the govt has to interfere in the market.

Y D Surplus S

PRICE FLOOR (Minimum price)

Price E

D

O X Quantity D. & S.

A price floor is above the existing price level.At this price, there is a surplus (excess) because S > D. Hence, the govt. should purchase these excess products at the price fixed by the govt. and store it.

This is called the buffer stock which is released through the ration shops during the shortage.

Buffer stock : Store House where the Govt keeps surplus goods to be released during scarcity. The Food Corporation of India (FCI) mainly undertakes this responsibility.

Minimum wage laws:are laws specifying the lowest wage which a firm can legally pay an employee.

Employers are prohibited from paying the less than the minimum wage fixed by the Govt. This similar to Floor price for the benefit of service providers.An example of price floor is the minimum wage.

Taxes & Subsidies:The Govt. interferes in the market through taxes and subsidies.

Tax:It is levied on a specific good. It is additional payment made to the Govt.

Subsidy:It is a monetary (money) help given to producers to encourage production of essential goods.

CLASS ACTIVITY

Creative Thinking:

1) Examine how the Govt. can interfere in the price mechanism for the benefit of farmers who produce essential commodities in Oman to obtain a reasonable for their products.

2) Explain how the Govt. can interfere in the price mechanism for the benefit of consumers in Oman.

(Good Luck)


ECON 121: Principles of Micro Economics Note: Students are required to refer the text, internet and other resource materials (Lecture points only)

Chapter – 4: The Public Sector (Read P.70 of Text without fail)

-Ref what to produce question?

Market Failure:Market failure implies that the forces of supply and demand have not led us to the best point on the PPC. This an imperfection in the market mechanism that prevents optimal outcomes.

The Optimal mix of output;The most desirable combination of output attainable with existing resources, technology and social values.

Ref. figure on Page 71. and draw in the graph book and write the summary.

What are the causes of market failure?

The four specific sources of market failure:1) Public goods2) Externalities3) Market power4) Equity.

Distinguish between Private goods & Public goodsA good or a service whose consumption by one person excludes consumption by others is called Private goods. Eg: dougnuts.

Public goods: A good or service whose consumption by one person does not exclude consumption by others. E.g.: defense services

Externalities:Costs or benefits of a market activity borne by a third party; the difference between the social and private costs (benefits) of a market activity. E.g. Cigarette smoking.

Overproducing goods that have external costs.Under producing goods that have external benefits

Market Power:The ability to change the market price of a good or a service.

Monopoly:

Natural Monopoly:An industry in which one firm can achieve economies of scale over the entire range of market supply.

Antitrust laws:Govt intervention to alter market structure or prevent abuse of market power.

Equity:-ref. for whom output is produced? Equitable distribution of income and wealth.

Public goods, externalities, market power, and Inequity cause resources misallocation (distribution of income and wealth not justifiable).

Hence, the importance of taxation.

Types of Taxation:

1) Progressive taxation: (P. 81)The rate of taxation rises as income rises

2) Proportional taxation (P. 82)Same rate on every Rial income.

3) Regressive Taxation (P.82)Tax rate falls as income rises. Up to a level of income no tax, after that tax is levied.


ECON 121: Principles of Micro Economics Note: Students are required to refer the text, internet and other resource materials (Lecture points only)

Chapter – 6: Cost of Production (Read P.126 of Text without fail)

Define productionProduction is the creation of utilities for the satisfaction of human wants.Here the four factors (agents) of production have to cooperate.

Factors of production:Resource inputs used to produce goods and services , such as land, labor, capital and enterprise.

Production function:A technological relationship expressing the maximum quantity of a good attainable from different combinations of factor inputs.

Productivity:Output per unit of input, for example, output per labor hour.

Efficiency (technical):Maximum output of a good from the resources used in production.

Short run: The period in which the quantity (and quality) of some inputs cannot be changed.

Lon run:A period of time long enough for all inputs to be varied (no fixed cost)

Cost of productions refers to the total payments (rent + wages + interest + profit) to the four factors of production (land, labor, capital & organization)

Three concepts of costs: 1) Real cost: refers to the mental and physical exertion + the pain, sacrifice involved in producing a commodity or service.

2) Opportunity cost: The next best alternative forgone. (ref. outcome – 1)

3) Money cost: Cost of production measured (or paid to the 4 factors) in terms of money.

Money cost is further divided into two:a) Explicit costs: (P. 141) Direct contractual payments made by an organization to the four factors of production. A payment made for the use of resources. e.g. Rent for land and factory building Wages to labor, interest for money borrowed from bank, etc.

b) Implicit costs:

The value of resources used, even when no direct payments is made.The costs of self-owned, self-supplied resources.E.g. the owner himself uses his own building as a factory for which rent need not be paid. He uses his own money instead of borrowing money from banks.

Short Run Costs : The short run cost of a firm is classified into Fixed costs & Variable cost. (P. 134)

1) Fixed costs: are the expenditures on fixed inputs used in production. E.g. Rent for land and factory building. (as land is a fixed factor). Fixed costs do not change even if the output is zero. Fixed costs remain fixed only in the short-run.

2) Variable costs: are the costs incurred on the variable inputs used in production. E.g. Raw materials, wages for labor, etc. Variable costs change with the level of production. When production is zero, VC is also zero.

Types of costs in the short run:

1) Total Cost (TC): Sum of total of fixed cost and total variable cost.TC = TFC + TVC

2) Total Fixed Cost (TFC): refers to the total expenditure on fixed factors of production. TFC remains same whatever be the volume of production.

3) Total Variable Cost (TVC): refers to the total expenditure on the variable factors.TVC = f (Q)

4) Average Fixed Cost (AFC): is obtained by dividing TFC by the total quantity of output (Q)

AFC = TFC / Q5) Average Variable Cost (AVC): calculated by dividing TVC by output (Q)

AVC = TVC / Q.

6) Average Total Costs (ATC): is obtained by dividing TC by the Quantity of output.ATC = TC / Q

OrATC = AFC + AVC

7) Marginal Cost (MC): is the addition made to the total cost (TC) when one more unit is produced. (Hint: take the differenced in total costs)The increase in total cost associated with a one-unit increase in production. (P. 132)

MC = TCn – TCn-1

Exercise on short-run costs: (ref. pages 132 onwards of text book)

From the table given below, calculate the various short-run costs and draw graphs. Quantity of output

TFC + TVC= TC AFC = TFC / Q

AVC= TVC/Q

ATC= TC / Q

MC (the differences in TC)

0 5 0

1 5 5

2 5 7

3 5 10

4 5 14

5 5 19

Show the relationship between Marginal Cost (MC) and Average Cost (AC) with help of a diagram. (Draw the diagram here)

1) When MC is below AC, it pulls the AC down and AC also falls.

2) MC cuts the AC curve through its minimum point. MC = AC

3) When MC is above AC, it pulls the AC up and AC also rises.

Long run costs: (P.142, 144)

All the factors are variable in the long period. Nothing is fixed in the long run. The firm can change its plant capacity. Since all factors are variable in the long run, there are only variable costs in the long run. In the long run we see only the Long Run Average Cost (LRAC), Long Run Marginal Cost (LRMC).

How to derive the Long Run Average Cost Curve (LRAC)?

It is also called as the “envelope curve” or “planning curve” because it envelopes a number of SRACs. It is called a “planning curve” because the firm plans its plant capacity on the basis of the behavior of LRAC.

(Draw the diagrams here – ref. pages 140 – 142 of textbook: The Micro Economy Today)




Part III: The Market Structure

Chapters – 7-10: Introduction: (ref. Page 156 of text book) Definition of market structureThe number and relative size of firms in an industry.

Definition of market:In Economics ‘Market’ for any commodity means a specific location or a place where buyers and sellers meet each other or are connected through telephone or other means of communication for exchanging goods or services for money.

Market Structures:There are four types of market structures on the basis of the number of firms and the type of product they sell in the market:1) Perfect competition

2) Imperfect Competition a) Monopoly/Duopoly b) Monopolistic competition

c) Oligopoly

1) Perfect competition:Perfect competition is a theoretical model of an ideal or best form of market.It is a market in which no buyer or seller has market power.

Market power is the ability to alter the market price of a good or service.

Competitive firm is a firm without market power, with no ability to alter the alter the market price of the goods it produces.

Features of Perfect Competition:

1) Large number of buyers and sellers:The number of buyers and sellers is so large like the tiny drops in the mighty ocean that no single buyer or seller can influence the market price.

2) Homogeneous product (one unit is exactly like another)All the units of the commodity sold are homogeneous (or identically equal to the other). Hence, buyers can buy from any seller.

3) Free entry & free exit:New firms can easily start business and existing firms can freely leave the market. There are no obstacles (eg: legal, technological, financial, etc) in entering or leaving the market.

4) Perfect knowledge of market conditions:Buyers and sellers have perfect or complete knowledge of market conditions, eg: what price is charged in every part of the market. Sellers, too, are aware of the activities of buyers and other sellers.

5) Perfect mobility:There are no barriers (hindrances) to the movement of buyers from one market to the other.

6) Price taker:Individual firms are price takers in this market. They cannot influence the market price. They can sell any amount at the given market price. (Ref.P.159)

7) Uniform price:There is only one and only one market price throughout the market. No one can control the price in this type of market.

The Production decision under Perfect c competition: (ref P. 159, 160….)

Output and Costs: Ref figures on TC, TR

2. Monopoly: (P. 195)

Pure monopoly or absolute monopoly is just the opposite of perfect competition. It exists when a single firm is the sole (only) producer of a product or service, which has no close substitutes.

E.g.: Postal services, telephone services (Govt. monopolies) Patented medicines, etc. (Private monopolies)

Features:

1) Single seller:A single seller or sole supplier of a product or service characterizes pure or absolute monopoly. No other firm produces this product / service.

2) No close substitute:There are no close or perfect substitutes for this product. The buyer has to buy this product at this price or go without it.

3) Price maker:The monopolist is a price maker because he has considerable control over the price. Besides he is the sole producer and seller of a commodity that has no close substitutes. E.g. Electricity production.

4) Barriers to entry:There are numerous legal, technical, natural and other barriers to the entry of new firms into the market. Hence, pure monopolist has no immediate competitors.

5) Monopoly power:A monopolist has the power to determine either the price at which to sell the product,OR, the quantity he wishes to sell. But he cannot determine both price and quantity because he cannot control demand.

The social desirability of monopoly (Disadvantages of monopoly)

1) Inefficient use of productive resources because the monopolist restricts output to increase the price and thereby earn maximum profit. This leads to underutilization of resources and excess capacity in the monopoly firm.

2) Consumers are exploited: By charging a high price.

3) Increasing income inequalities: The income is transferred from consumers to the monopolists because monopolists have excess profits. It leads to concentration of wealth in the hands of a few.

4) Unfair trade practices: A monopolist adopts unfair trade practices to stop entry of new firms into the market.

5) No product & technical innovations: A monopolist may not be interested in introducing a new product or any improvement in the existing product. He is fully aware that he has no competitors. This hinders technical progress in the economy.

3) Monopolistic competition:

Monopolistic competition is a market situation in which there are a large number of small firms making similar but not identical products. It has both the features (elements) of competition and monopoly.

Features of monopolistic competition:

1) Relatively large number of firms:There is relatively large number of small firms producing and selling similar products (but not identical products). E.g.: different toothpaste companies.

2) Similar but identical products:Each firm sells differentiated products. The toothpaste manufactured by one company is not exactly identical to the other company’s product. The differentiated products give some degree of monopoly power to each firm.

3) Product differentiation:This is the most distinguishing feature of monopolistic competition. There are two types of product differentiation

a) Real differentiation: refers to real improvements in quality, quantity, materials, design, etc.

b) Imaginary differentiation: refers to trade mark, brands, color, packing, etc.

4) Small market share:Each firm has a small percentage of the market share. Hence, each firm has limited control over the market price.

5) Easy entry and exit.No barriers to the entry of new firms or exit freely. Hence, there will be stiff competition. However, patent rights, copyrights, trademarks, etc, make it difficult for other firms to imitate the existing products.

6) Selling costs: This is also a distinguishing feature of monopolistic competition, in addition to product differentiation. They are in the form of advertisements & publicity, show rooms, window display, free samples, incentives to sales persons, etc.

4. Oligopoly:

Definition of oligopoly:Oligopoly is a market situation in which there are very few large firms exist. In other words, oligopoly is imperfect competition among a few. These few firms produce a large amount of output. They are very powerful and big in market-terms.

Examples, Industries producing oil, tyres, cars, cigarettes, etc.

O.P.E.C. Organization of Petroleum Exporting Countries.

Features of Oligopoly:

1) Few large firms:Few large firms dominate the market.

2) Similar products:The products in this market are similar to each other, example, cement, sugar, cars, newspaper, petroleum, etc.

3) Barriers to entry:There are strong barriers to entry of new firms because the existing firms are big and they enjoy economies of scale (advantages of large scale operation).

4) Sticky prices:The price of the product is sticky. In other words, the selling price does not change very often.

5) Interdependence:The few firms under oligopoly market are interdependent. The price and output decision of one firm totally depends on the decisions of the other. In other words, the actions of one firm affect the other firms.

6) Non-price competition:Each oligopoly firm adopts non-price competition. They make use of brand names, distinctive packing, free gifts, after-sales services, guarantees, etc . to increase the sales.

7) Collusion:Collusion occurs when price & quantity fixing agreements among producers are explicit.In other words, when firms agree to cooperate in order to restrict (control) output and raise prices, their behavior is called explicit collusion. Tacit collusion occurs when such agreements are implicit.

8) Formation of cartel:This is one form of explicit (open) collusion.A group of firms that get together and make joint price & output decisions to maximize joint profits. Firms produce separately, but act as one in determining output and price. A typical example of cartel is OPEC.

9) Kinked demand curve: (ref. P. 225 and draw the diagram)It is a model of oligopoly in which the demand curve facing each individual firm has a “kink” or a bend in it. It means, if a single firm cuts price the other firms also cut prices. If a single firm raises prices, the other firms will not raise prices.The kinked demand curve shows oligopoly price stability and interdependence.

In the above figure, the curve DGD is the demand curve of the oligopoly firm. Price = OPQuantity = OQThe demand curve is kinked at G. Hence, it has two segments:The upper segment DG is elastic while the lower segment GD is inelastic (relatively)At price higher than OP, demand is very elastic.Hence, competitors will not follow an increase in price above OP.

At price lower than OP, demand is inelastic. A price-cut below OP will be followed by the same reactions from the Oligopoly competitors. But their profit will be less. Hence, oligopoly competitors generally keep the price stable. In turn, they adopt non-price competition.

5) Price leadership:A form of oligopoly in which one dominant (leader) firm sets prices and all the smaller firms in this industry follow the pricing policy of the leader.

Role of competition policy & the regulation of natural monopolies in economic performance:

Comparison between perfect competition & MonopolyPerfect competition Monopoly

Number of sellers Large number of sellers Single sellerProfit Normal profit Supernormal profitEntry & exit No barriers (easy and free) Barriers (not easy)Control on price Price taker, no influence on price Price maker, has influence Nature of D. curve Perfectly elastic Relatively inelasticOutput & Price Competitive output is Greater,

Competitive price is lessMonopoly output is restricted, price is usually higher

Social desirability Socially desirable Socially undesirable.However, Govt. monopoly is good, but private monopoly is bad unless controlled.

Role of competition:What prevents other firms from entering the monopoly market? If a monopoly exists, it exists due to some type of barriers to entry of new firms. Barriers to entry:Obstacles that make it difficult or impossible for would-be (future) producers to enter a particular market, such as patents, etc. Exclusive rights to produce a particular commodity are patent rights.There are three important barriers to entry of new firms;

i. Natural abilityii. Economies of scale

iii. Govt. restrictions

If there are no barriers to entry, there will not be monopoly. This is one of the main reasons why economists generally support free international trade (competition among countries in terms of trade.

Natural monopoly:A natural monopoly is an industry in which a single firm can produce at a lower cost than can two or more firms. Natural monopolies exist in industries with strong economies of scale. Hence, it is more efficient for one firm to produce all the output, instead of leaving to competitive firms. Here, economies of scale act as a “natural” barrier to entry.

What do you mean by economies of scale?Reductions in minimum average costs that come about through increase in the size (scale) of plant and equipment. If larger firms have a substantial cost advantage over smaller firms, the smaller firms may not be able to compete with these monopoly firms.

In some industries, there are technological economies of scale so large that it makes sense to have one firm. Examples, electric company, telephone company, etc.

Govt. monopoly is good, but private monopoly is bad unless regulated. Why?

The regulation of natural monopolies in economic performance:

Remedies for monopoly: Antitrust policy.

The Governments have assumed numerous roles in controlling and regulating imperfectly competitive industries (esp. monopoly industries)

1) All governments promote competition and restrict market power, primarily through Antitrust laws and Acts.

2) They restrict or control competition by regulating industries.

3) Govt. ownership of industries (Govt. Monopoly)

4) Industrial Policy Resolutions of Govt. to regulate them.

Antitrust policy of Govt:

Antitrust policy is the government’s policy toward the competitive process. It is the Govt’s rulebook for carrying out its role as referee. In business, a referee is needed for such questions as:

a) When can two companies merge?b) What competitive practices legal?c) When is a company too big?d) To what extent is it fair for two companies to coordinate their pricing policies?e) When is a market sufficiently competitive or too monopolistic?

Hence, Government intervention is necessary to alter market structure or prevent abuse of market power.These laws or Acts give the government broad antitrust authority to break up monopolies or compel them to change their behavior.

Market power:The ability of a firm (usually monopoly firm) to alter (change) the market price of a good or service (Price-maker)

(Space for references from books and internet)

ie summary - جامعة نزوى · web viewdraw the production possibility curve on a graph paper...

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